subprimes

In finance, subprime lending (also referred to as near-prime, non-prime, and second-chance lending) means making loans to people who may have difficulty maintaining the repayment schedule, sometimes reflecting setbacks such as unemployment, divorce, medical emergencies, etc. These loans are characterized by higher interest rates, poor quality collateral, and less favorable terms in order to compensate for higher credit risk. Many subprime loans were packaged into mortgage backed securities (MBS) and ultimately defaulted, contributing to the financial crisis of 2007-2008.

Proponents of subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market. Professor Harvey S. Rosen of Princeton University explained, "The main thing that innovations in the mortgage market have done over the past 30 years is to let in the excluded: the young, the discriminated-against, the people without a lot of money in the bank to use for a down payment."

The term subprime refers to the quality of particular borrowers, who have weakened credit histories and a greater risk of loan default than prime borrowers. As people become economically active, records are created relating to the borrowing, earning and lending history. This is called a credit rating, and although covered by privacy laws the information is readily available to people with a need to know (in some countries, loan applications specifically allow the lender to access such records). Subprime borrowers have credit ratings that might include:

• limited debt experience (so the lender's assessor simply does not know, and assumes the worst), or
• no possession of property assets that could be used as security (for the lender to sell in case of default)
• excessive debt (the known income of the individual or family is unlikely to be enough to pay living expenses + interest + repayment),
• a history of late or sometimes missed payments so that the loan period had to be extended,
• failures to pay debts completely (default debt), and
• any legal judgments such as "orders to pay" or bankruptcy.

Lenders' standards for determining risk categories may also consider the size of the proposed loan, and also take into account the way the loan and the repayment plan is structured, if it is a conventional repayment loan, a mortgage loan, an endowment mortgage, and interest only loan, a standard repayment loan, an amortized loan, a credit card limit or some other arrangement. The originator is also taken into consideration. Because of this, it was possible for a loan to a borrower with "prime" characteristics (e.g., high credit score, low debt) to be classified as a subprime.

Although there is no single, standard definition, in the United States subprime loans are usually classified as those where the borrower has a FICO score below 640. The term was popularized by the media during the subprime mortgage crises or "credit crunch" of 2007. Those loans that do not meet Fannie Mae or Freddie Mac underwriting guidelines for prime mortgages are called "non-conforming" loans.  As such, they cannot be packaged into Fannie Mae or Freddie Mac MBS.

A borrower with an outstanding record of repayment on time and in full will get what is called an A-paper loan.  Borrowers with less-than-perfect credit 'scores' might be rated as meriting an A-minus, B-paper, C-paper or D-paper loan, with interest payments progressively increased for less reliable payers to allow the company to 'share the risk' of default equitably among all its borrowers. Between A-paper and subprime risk is Alt-A. A-minus is related to Alt-A, with some lenders categorizing them the same, but A-minus is traditionally defined as loans lacking full documentation. The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien subprime mortgages outstanding.

Sources:

http://en.wikipedia.org/wiki/Subprime_lending